If MCS clients were one large portfolio, the year-to-date return through September 30th was 6.42%. Individual client returns ranged between 3.09% and 11.50%. The client with the lowest return was negatively impacted by exposure to European stocks and had fewer bonds overall. The client with the h ighest returns had a significant portion of zero coupon bonds which post large gains when interest rates fall. Auxier sub-portfolios, on average, gained 1.97%. The Auxier results are included in the total client results above. So far this year, Auxier results have been a drag on client returns; last year it was the opposite. Auxier results compared to the S&P 500 have lagged significantly this year. It’s not uncommon for value managers like Auxier to be out-of-sync with market returns for several quarters, but I’ll be monitoring this closely. For comparison purposes, the S&P 500 Total Return Stock index gained 8.35% and the Barclays Aggregate Bond Index gained 4.09% for the period.
My second quarter report ended;
“Strategy: continue to be highly selective with any investment buys; keep cash on hand for opportunities when events go wrong and investment prices are lower. Be patient.”
Well, events have ‘gone wrong’; stock market volatility returned in late September and continues into October. US stock prices had been grinding higher since January /February lows. I’ve been writing to you about my concerns of a decline in stock prices based on an improvement in the US economy and increase in interest rates. The US economy is indeed improving; the Fed is ending its bond buying program in October and unemployment is now below 6%. Inflation is well behaved and the Fed keeps reassuring investors that change in interest rates is data dependent and will likely be gradual.
But there’s Trouble. Trouble with a capital “T” and that rhymes with” D” and stands for deflation! (Apologies to Meredith Wilson; writer of lyrics and music for the 1957 Broadway hit, The Music Man) Despite the improving US economy, fears of deflation, an old nemesis of the stock market has returned. The hoped for global economic recovery is faltering in Europe and Japan. When coupled with below expected growth in China, there’s fear that the US economic recovery is threatened by these non-US risks.
The stock market is concerned with three risks
- The US dollar has strengthened against the other major currencies; the Euro and Yen. S&P 500 companies derive roughly 33% of sales and 45% of profits from foreign sales. Thus a strong US dollar reduces the earnings of US companies’ foreign currency sales and sales growth. An investment narrative circulating now is that the US dollar will keep gaining strength against other major currencies for several years.
- The US ‘imports’ deflation. Because the US runs a trade deficit (it imports more than it exports to other countries), falling prices for goods from those countries would put downward price pressure on competing US goods and profit margins. See Figure 1.
- The uneasy prospect that today’s ultra-low rates are a harbinger a recession in Europe and Japan (bad for stocks) and not the actions of a super accommodative* central bank’s willing to do anything to keep the economy growing (good for stocks).
*This includes manipulating interest rates to historic lows and flooding the banking system with money.
Eurozone Businesses Cutting Prices
Source: Markit | WJS.com
What I’m thinking about.
In 2012, European stock and bond prices were dropping on fears that a weak recovery would leave counties like Spain and Italy unable to service their debts due to growing government budget deficits. The contagion from the Greek debt crisis (Greece defaulted on its debt) drove up interest rates on Spanish bonds to the 7% range and seemed to threaten the future of the European Union. 2012 was a volatile year for US stocks due to these non-US risks.
As of October 17th 2014, the interest rate on relatively risky Spanish and Italian ten year government debt is 2.16% and 2.49%, respectively, while the relatively safe US 10 year Treasury yields 2.19%. This is wacky; not the ‘funny’ kind of wacky but the ‘someone could really get wacked’ kind of wacky. There is no ‘default’ risk premium in the Spanish bonds. A default risk premium is the extra yield the investor demands to compensate for the risk of not getting paid as agreed. Greece is making default noises again and concerns about the Eurozone’s
weaker credits (Spain and Italy) can’t be far behind. If bond rates in the weaker economies of Europe (Spain and Italy) were to start rising again due to default fears, it would send a negative shock to global bond and stock markets.
10 Year Interest Rates; US Treasury vs. Spanish Treasury Bond
Since my second quarter newsletter, oil prices have plunged from roughly $104 BLL to $83 BLL. See chart. I commented that rising geopolitical risks to oil supplies could push oil prices higher. Since then two important events have occurred; 1.) the US committed greater military involvement in the Middle East which reduces the risk on a strong ISIS foothold and 2.) the Saudi’s indicated that they would drop oil prices to maintain their market share. It’s believed in some circles that the Saudis goal is to 1.) maintain market share with Asia and 2.) slow the development of US shale gas reserves. Lowering the cost of oil makes high cost extraction methods uneconomic. A recent Bloomberg article countered that US shale gas producers have been lowering their cost of production to between $30 and $60 per barrel equivalent so it’s unclear whether current prices would impact shale gas development.
The drop in oil prices is positive for US consumers; allowing them to shift their spending to other items. I feel this mitigates some downside risk to the US economy.
Crude Oil WTI (NYMEX)
Source: Nasdaq Website
Many oil and gas related investments have been hard hit with the drop in oil prices including a favorite income of retirees; master limited partnerships (MLP’s). The chart below traces the year to date price changes of Exxon, a high yield MLP (Legacy Reserves L.P.) and the S&P 500 Index. Figure 4 is very instructive about the risk that exists in today’s markets. Until September, MLP’s like Legacy represented a very profitable way to get high income. MLPs are required to pass 90% of income through to investors. If oil prices increase, MLP income increases; a reasonable bet if the economy grows and the Middle East remains a high risk zone.
Legacy Reservces LP (LGCY)
Source: Yahoo Finance
Here’s the rub; when the world turns out differently than expected, prices decline on riskier investments extremely swiftly and painfully. Exxon looks like a dog the entire year until the market cares about quality; then the real differences show up – it is down only a fraction of LGCY’s loss while the S&P 500 is barely positive.
This presents a wild card in terms of financial risk. Specifically, a panic which shuts down transportation and economic activity as fear keeps people away from crowded places including perhaps work places. I do not know how to quantify this risk. The contagion of fear can spread far more quickly than the any virus. In such an event, stocks would suffer. There would probably be a flight to safety pushing high quality bond prices up temporarily. Cash would be safe as well.
Currently, I am in agreement with the consensus that the US economy is unlikely to fall into a recession. Global economic problems including a possible recession in Europe will be a headwind for US economic growth but are unlikely to derail it.
High quality bonds have reassumed their safe haven role. Bond prices have appreciated as investors increased their buying of high quality investments and yields dropped. While it is gratifying to know your money is in safe, good performing investments during this turmoil, the longer this environment persists the more problematic it becomes to earn a reasonable return over the next decade. I am struggling to find enough attractive bonds for clients – bonds offering some margin of safety in a rising inter est rate environment. Many mistakes are being made by investors desperate for yield, who don’t understand the downside risks of what they are buying.
Expect more volatility as the markets sort out impact of the global economic problems on US economic growth and profitability of US companies. As I’m writing this newsletter there has been a rapid bounce back in prices of many stocks, including the MLP’s that I discussed under the oil section. It feels too fast. Economic fundamentals of some investments are shifting for the worse while US economic growth remains intact. When money pours back into beaten down stocks or MLPs within a week, it’s a warning sign of a more speculative / hair trigger environment.
I believe that the benign backdrop of steadily rising stock prices with only minor setbacks is ending. We are well positioned for a more volatile environment. Cash has been building in most client accounts as bonds have matured and I look forward to putting it to work as opportunities to ‘buy low’ present themselves.
1MCS Family Wealth Advisors (MCS) client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary accounts under management since 12/31/2013. These accounts represented 96% of MCS’s assets under management as of 09/30/2014 and were invested primarily in US stocks and bonds (19% of the Income/Growth assets on 09/30/2014 were invested in tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Barclays Capital US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.